The New York Stock Exchange in its pre-index days (i.e. 1963). Image via Getty.
The SpaceX IPO has
triggered another outbreak of an old gripe on Wall Street: Passive index-fund investors, it’s said, are overinflating stock prices and creating a market-wide “bubble.” (Last week, the company was added to the Nasdaq-100, although its price subsequently dropped during a bad stretch for tech.) Even before the SpaceX launch, the
Economist reported that a 2021
working paper which shows how a passive-investing bubble could develop was
circulating in the finance industry;
Big Short hero Michael Burry
made the bubble accusation on a podcast in late 2025 with bestselling author Michael Lewis. If you’re reading this newsletter, it’s entirely possible that you’re a passive index investor. Should you feel bad about that—or do something about it?
How index investing worksPassive investing—putting one’s money into an entire market’s worth of stocks, typically via funds that hold an
index like the S&P 500®, and then leaving it alone—has been a great deal for investors for several decades. Every year, on schedule,
tallies show that passive strategies continue to outperform most stock-picking “active” funds over the long run.
The potential problem, in theoryWhen index funds put new customers’ money into the stock market, it has to go into the companies that make up a given index, increasing demand for those shares. One could imagine a world in which passive, undiscriminating flows consistently inflated the value of entrenched index constituents well past what was justified by their performance or the broader state of the economy. (And it’s true that stock prices right now, relative to companies’ actual earnings, are historically speaking on the
high side.) Eventually, though, reality could catch up to some of these companies—via a major scandal, let’s say—and their stocks would suddenly plummet in worth, potentially triggering a wider panic. (Indexes can and do drop problematic members, which forces automatic selling by index funds; as it happens, the S&P 500®
replaced Enron with Nvidia.)
Why people are still talking about this one studyOne way that passive investment inflation could be avoided, in theory, is if passively managed
inflows were regularly offset by actively managed
outflows. In the scenario described above, for instance, active investors who believed that valuations were getting too high would have an incentive to sell their shares to avoid future losses.
What the researchers from Harvard and Chicago
found is that, on average, this doesn’t happen. Each new dollar that goes into the stock market, they report, pushes the market’s total value up by about $5. (If you’re wondering how exactly that works, Gabaix told us to think about the “inelastic demand” created by automatic index-fund buying. A buyer who is obligated to purchase shares of Index Company X at any price is going to push that price higher than one who could take it or leave it.)
But is the call also coming from inside the house?The people complaining that indexes are causing bubbles are usually active fund managers, who have lost a lot of business in recent decades to passive funds charging lower fees for what are often better results. And there are still a
lot of active managers—Morningstar reports that there are
$16 trillion worth of assets under active management in the US, nearly half the market—plus an increasing number of retail investors engaging in active trading themselves.
History shows that active traders’ collective ability to discern when stocks are overvalued is not great. Mania-driven bubbles certainly
precede the 1970s origins of index investing. A recent Morningstar examination found that during market downturns—when an ability to spot distortions and overvaluations would conceivably be rewarded—active managers have
still been outperformed by indexes. Recently, a number of high-profile stocks have recovered from losses because of retail traders “
buying the dip”; in plain English, what that means is that when one set of active investors thinks a certain company has gotten overvalued and starts selling, it’s often another set of active investors, rather than index funds, who are rushing in to keep its price up. (Like with everything else, you can probably
blame the phones for this.)
The equivocal but empirically grounded conclusionWhat this whole debate is really about, perhaps, is a question more fundamental than active vs. passive: Are there too many investors in the market right now,
period? After all, even if there weren’t index funds, there would still be a lot of regular individual investors putting money into stocks, and probably into the biggest and arguably most overconcentrated ones. (Like SpaceX—although its price is lower now than it was before it gained automatic Nasdaq-100 inclusion.)
If it’s unsettling to you that no one really knows the answer to that question, consider that the best way to prepare for a potential bubble-popping, historically, has been … keeping money in passive index funds. As mentioned, indexes still seem to outperform active funds in hard times; studies have meanwhile found that index investors who try to
time the market (i.e. selling their stock holdings and moving into bonds or cash because they think a downturn is imminent) usually end up worse off than those who don’t. The financial writer Ben Carlson periodically notes that if you could go back and put all your money into diversified stock holdings on the
absolute worst days to do so in the history of the US, like the day before the 1929 crash, you would still have ended up with
solid returns in the long run.
There are no guarantees in investing. (Or in life, dude.) But index investors have made a lot of money since the ’70s by owning broad swathes of the market while paying low fees. If there’s a strong case that they should stop doing that for their own health, let alone the health of the market at large, it hasn’t revealed itself yet.
Thanks to professors Xavier Gabaix of Harvard and James Angel of Georgetown’s Psaros Center for Financial Markets and Policy for their insight on this issue.
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